While the American economy continues to grow at a tepid pace, the filing rate for both personal and business bankruptcies has slowed dramatically. As banks have cleared many, but certainly not all, of their problem loans and have curtailed lending activity, the main driver of small- and medium-business bankruptcies has slowed. However, like death and taxes, bankruptcy is not going to go away. The retail sector appears to be primed for the next wave in bankruptcy filings, and that means that vendors, suppliers, and other creditors should be prepared.
The main driver of what could be the next wave of major bankruptcies is technological change. Big box retailers like Best Buy, J.C. Penney and Barnes and Noble have one advantage over online retailers like Amazon: a physical presence across the nation. Approximately 90% of the American population is within a short drive of a Best Buy store. However, this is also a double-edged sword for retailers. When the economy declines, retailers must shed costs and do so as quickly as possible. But all that brick-and-mortar real estate comes with frequently-expensive leases that cannot be easily escaped without substantial payments—and for a company that is already starved for cash, those leases can become an economic albatross.
One of the signs of an impending retail bankruptcy can be found in the cash burn rate. Towards the end of a retailer’s financial viability, they will begin running out of unencumbered assets that can be used to pay suppliers and other vendors. Especially in businesses that are highly seasonal—such as clothing retailers, a lack of liquid assets at a critical time can be fatal. Already, the financial statements of several major retailers are showing a large cash burn rate and declining same-store sales. These are signs of systemic weakness in the retail sector that could push businesses that have been teetering on the edge into bankruptcy.
This does not mean that these retailers will be filing bankruptcy soon—there are always possibilities for a workout with secured lenders that frees up cash or the holiday season could produce enough revenue to start easing or even reversing the burn rate. However, if consumer spending declines that burn rate could increase to the point where bankruptcy is the only option.
What this means for vendors and suppliers is that they face a difficult choice: if they alter the terms of their contracts with major retail clients who are in financial distress, they run the risk of incurring liability for preferential transfers down the road. Any transaction that is outside the “ordinary course of business” may become subject to avoidance by a bankruptcy trustee if made within 90 days of a bankruptcy filing. At the same time, companies at the brink of bankruptcy will often seek special arrangements to ease cash flow concerns. However, this can take payments outside of the ordinary course, making them subject to preference recovery down the road.
Companies doing businesses with potentially insolvent customers can do a few things to minimize their liability. The first is to keep detailed books and records: the most crucial part of a defense to preference liability is to have accurate records that establish an ordinary course of payments. Second, if there is a problem with payments being considerably late, a vendor can demand prepayment for shipments. While this may make the business relationship more difficult, it allows the creditor to claim a new value defense to preference liability.
The current economic situation remains unsettled, especially in the retail sector. Retailers of all sizes are facing national and even global competition at the same time their assets are diminishing due to slow sales and expensive leases. While the situation remains fluid for many major retailers, the risk of a wave of bankruptcy filings remains elevated. Awareness of the risk and taking steps to minimize future liability for preferential transfers can ensure that vendors and other creditors do not find themselves stuck in an untenable position if a major customer files bankruptcy.